Treasurys rise as Spanish bank's failure fans fears

Yield curve flattest since October as longer-dated debt leads rally

By

DeborahLevine

NEW YORK (MarketWatch) -- Treasury prices rose slightly on Monday, pushing long-term yields down to 2010 lows, as the euro and stocks came under selling pressure after weekend news that the Bank of Spain had taken over a lender, reviving fears about Europe's banking sector.

Yields on 10-year notes
TMUBMUSD10Y, +2.09%
fell 2 basis points to 3.22%, hovering near the lowest level seen on a closing basis since last October.

Last week, yields on short-term securities reached the lowest since November 2009. The two-year's all-time low, reached during the depths of the financial crisis, was 0.65%.

The global shock that the European crisis might create could weigh on equities and confidence in general, said bond strategists at CRT Capital Group. "People are not positioned for a slowdown economically in the second half of the year or beyond," they said.

Also indicating rising strains in financial markets, the three-month U.S. dollar London interbank offered rate, or Libor, rose to 0.5097% -- the first time it had risen above 0.5% since July 2009.

Bonds gained last week on increasing worries that the problems in Europe will slow global growth. Those fears have investors shifting away from riskier assets including stocks and high-yield debt and toward the relative security of U.S. debt. Read about recent bond activity.

Treasurys of all maturities have returned nearly 2% already this month, the best month-to-date performance since December 2008, according to an index compiled by Bank of America Merrill Lynch.

By contrast, high-yield bonds have lost 3.8% in May, while the S&P 500 equities index
SPX, +0.32%
has dropped 8.3%.

"The rates rally momentum is intact, so unless stocks and the euro catch a firm bid this week, we believe there is still some fire in this bond market rally heading into June," wrote George Goncalves, bond strategist at Nomura Securities, in an email.

Bull flattening

Another phenomenon bond analysts have been watching is the flattening of the so-called yield curve, namely the gap between 2-year and 10-year yields.

The flight to quality out of riskier assets has benefited longer-dated debt more than usual as investors see very little chance of a big rally in short-term debt because the Federal Reserve already has benchmark rates at record lows near zero.

Also, because of the concerns that growth will be weak, inflation expectations are fairly low. Low inflation supports longer-dated securities, which are typically more sensitive to fears about rising inflation.

"Monetary policy is locked down at the lowest rates and inflation is benign," said Chris Ahrens, a bond strategist at UBS Securities. "There is pressure to generate returns in risk-free assets so investors are forced to move out the yield curve," causing what's known as a bull flattening -- longer-dated yields fall faster than shorter-dated ones.

"That's not a normal, frequently occurring event," Ahrens said.

The gap between 2-year and 10-year yields has fallen to 2.47 percentage points, the lowest since October and down from as much as 2.93 points on Feb. 18.

The bull flattening could continue as the flight-to-quality environment drives people into bonds but they still want some price appreciation as yields fall, Ahrens said.

Bonds showed little reaction to the only economic data of the day, showing U.S. existing-home sales rising 7.6% in April to a 5.77 million-unit pace, mostly attributed to an expiring tax credit. Read about home sales.

Auctions on tap

Short-term securities may lag the rally as the government plans to sell $113 billion in notes this week, all with maturities of seven years or less. The total is $5 billion less than the last round of sales of the same maturities, following through on the government's intention to reduce auction sizes as the deficit outlook becomes clearer.

"With financial market concerns weighing heavily on investor psyche, and amid growing concerns that the sovereign debt crisis will slow the recovery, Treasurys continue to garner a strong flight-to-quality bid that should make for relatively good auction," said analysts at Action Economics.

Still, the recent rally has made yields on the to-be-issued securities much lower than last month's sales, possibly reducing their appeal to investors, they said.

The 2-year notes to be sold this week are currently trading around 0.78%, according to Action Economics, compared to April's auction at a yield of 1.02%.

The upcoming 5-year debt is trading around 2.02% versus 2.54% last month, and the new 7-year notes are trading near 2.66%, down from 3.21% in April.

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